Daily Speculations
Vic Answers Readers’ Questions
Quality and Quantity
Q. Just wondering if there's a way of finding the optimal relationship between the quality and quantity of the trades that one makes. What are the factors that should be considered here? I wonder, for example, if there's an argument for risking less capital on less compelling trades. Vic advocates using smaller position sizes with shorts, but then why not apply the same criteria for long trades where the Z is OK but not great? -- N.
A. This is a very hard and good question. The closest I can come to help is that I like to make a trade with more than one way that I can stay with it if it doesn't do exactly what I wish. For example, if I buy, after three days long if it goes against me on the fourth day I could still be long. Many trades look good for an hour but if they don't go in the required direction there is no reason to hold them and these are bad trades. It is wrong to try to strive for perfection on a trade. I like to have a trade where the numbers are in my direction for both the short and long term.
Ruminations on Risk
Q.
My understanding of Sharpe Lintner CAPM proposes that
portfolio returns in
excess of market returns are explained by a slope coefficient
(beta) such that
the intercept (alpha) of such regressions is not statistically
different from
zero. Beta is market risk; more up when the market is up, and
more down when
the market is down. Risk here seems to mean that investors
require higher
returns from more volatile portfolios, perhaps because the
path is more
unpleasant than less volatile portfolios. Or possibly the risk
that one's
investment goals won't be met due to extreme fluctuation in
the port return
over periods relevant to the investor's consumption needs.
True?
CAPM failed to explain certain return anomalies, the size
effect, and B/M
effect. Ports constructed of either very small stocks, or ones
with high B/M,
show significant alphas. Fama and French in 1993 proposed a
new asset-pricing
model which added two more "risk" factors to the CAPM
equation. They adjust
for the size effect, and the B/M effect, and derive a
4-dimensional linear
function from regressions. This 3-factor function's intercept
(alpha) is now zero for
ports of small stocks and high B/M. Are these additional
factors independent
proxies for risk not captured by beta? If so, just how is risk
defined here?
Small firms and high B/M can be distressed, and vulnerable to
bankruptcy, etc.
But if this is the kind of risk these factors seek to adjust,
wouldn't small
and high B/M ports underperform the market (due to firm
liquidations, etc)?
I also read a paper where the authors added a fourth factor to the Fama French model, one for momentum (the Jegadeesh and Titman anomaly). This anomaly (the short-term continuation of high returns) shows significant alphas even in the Fama French 3-factor model. Do high momentum stocks incorporate some type of added risk not captured by other regressions? Or is is possible that the EMH crowd will always attempt to adjust out anomalous returns as new, independent, risk factors? What exactly is the definition of risk?
A. The Fama French stuff is completely outdated because it doesn't take account of the last 25 years. Moreover, it used retrospective data, and the risk measures don't take account of the semi variance, which is of more concern, i.e. the variability of negatives not the positives. In any case they aren't predictive going further. Your analysis leaves out the non-diversifiable risk, that is key. As to why people avoid risk, gambler's ruin, and the possibility of leverage, would seem to be more applicable to me than the path.
What Does the Trade Deficit Signify?
Q. The U.S. trade deficit keeps growing. When this happens in other countries, it leads to devaluation and economic disaster. Some very smart people say they are shorting the dollar because of the trade deficit. Should I be concerned? How can I protect myself? (July 6, 2003)
A. A good place to start in considering trade deficits is Chapter 1 of any modern economics book, like Paul Heyne’s The Economic Way of Thinking, or Steven Landsburg’s books. Both explain the principles of comparative advantage and how trade benefits both parties even if one country or one person is technically superior in producing both products. They also show how to apply the principle to trade between you and the supermarket, or between New York and Alabama. Comparative advantage explains why we are so specialized, and why the division of labor develops, and why this is the source of our material wellbeing and political freedom. (See Henry Simons, the founder of the Chicago tradition of monetary economics, as to how freedom in trade is the key freedom.)
This is why the destroyers are always against free trade and free immigration, and often come up with non-economic shibboleths to worry about trade deficits for no economic reasons. Why is not the desire for long-term investment in a country the drivers that determines whether the current account will be such that they balance? The two must be considered simultaneously.
Reader Brian Haviland comments: Clearly free trade is the way to go in the long run. Maybe we get pain in various areas (like steel?) but better in general we should continue to use our energy and minds to continue to come up with new ways to produce value that the rest of the world has not thought of yet as opposed to desperately trying to keep businesses going that are better served elsewhere. I guess I'm wondering, though, how the currency issue will play out. If the other countries keep sending dollars back to keep the dollar strong and their exports cheap, is there some kind of diminishing return point where they are putting in more than it's worth for them? Perhaps this point might start when the markets or we ourselves start to force the dollar down, leading to a stiffer price tag for those wanting to invest here? I wouldn't think that this would of necessity lead to a disaster -- maybe just some shifts in flows of trade and currency.
Paul DeRosa points out a practical exception to my theory: I think what you say here is accurate with regard to Europe, where the trade account is simply the mirror image of a capital flow. I'm not so sure about Asia, however, since it looks like government intervention that is keeping exchange rates so low.
Syllogistic Reasoning
Q.
My
thesis at this time is demonstrating that stock shares are a
form of
counterfeit money.
I do not see how this can be counted.
The first and only tool I see is syllogistic reasoning.
I put this to the list for ideas and syllogisms.
A: I have often felt that syllogistic reasoning could
be very useful in stock
market research. Often there is an accepted hypothesis of the
form
"No A are B." For example: No stock market rises can occur
while bonds
go down. As long as stocks go up and bonds go up, that
hypothesis is not
refuted. But as soon as the "No A are B" is falsified by a
"Yes, stocks went up
while bonds went down," the previous hypothesis has to be
changed and a new, much
higher paradigm and stock market may arise.
I have used this
often in all my qualitative speculations, and it seemed to
me that this variant of Popperian falsification was the key
lasting insight that
Soros had.
Non-predictivity of industrial production
Q. 11 of the past 13 times the year-to-year rate of change in industrial production has dropped below -.5%, a recession follows. The current cycle in industrial production topped out in June of '00, five months after the all-time high in the Dow. It dropped below 0.5% in 3/01 and stayed below 0 until 7/02. Ironically, months after that NBER declared a recession. 3/01 marked the second straight month of declining industrial production year-over-year. Industrial production topped out again in 7/02, four months after the top in the Dow. 4/03 the year-to-year rate of change in industrial production dropped to -0.6% and just last month it was -0.8% the second consecutive year-to-year decline. I know we are a service economy but is that because our industrial economy is on the rocks? If the dollar continues to weaken who is going to buy U.S. goods?
(June 23, 2003)
A.
Doc Greenspan was known as one of the worst
forecasters of all time with his previous firm of Townsend Greenspan. He relied
heavily on blast furnace statistics and industrial production data. That's one
of reasons I knew he couldn't have earned a legitimate PhD, and it's why I like
to call him Doc Greenspan the same way the same way W liked to affectionately
call Teddy by the nickname "Chappie" before the election, but this is
too much vis-a-vis industrial production. In the very erudite introduction to
Philip Carrett's book, a countist I respect measured the influence of
industrial production on future stock prices, and found a highly negative
correlation. The into to this book by the 100-year-old Carrett is always worth
a smile and sobering influence on following industrial prod stats into the
abyss of wrongful stock market moves.
A Well-Read Member of
the Old Speculators' Assn. adds:
Here is the passage in question:
Philip Carret "The Art of Speculation" , Paperback edition, March 20,
1997
Foreword, Page xiii
Begin Quote
Among Carret's cornucopia of suggestive studies, aphorisms and insights into
the history of speculation, my personal favorite is the blast furnace index.
The legendary Cleveland statistician, Colonel Leonard Ayer, discovered a
remarkable correlation between the present state of blast furnaces and the
subsequent trend in the stock market. When the blast furnaces in use rise
above 60% of the total number, it is time to sell stocks. When the number in
use falls below 60%, it is time to buy stocks. This index and many like it
were eventually incorporated by Townsend and formed the basis for his
forecasting service in the 1940's. Townsend eventually formed a partnership
with one of his brightest operatives, a small economist with a predilection for
number crunching and, developing new indicators - especially those concerned
with the physical movement of commodities, Delphic pronouncements, backhand
slices, sound money, and objectivist studies - who after his start as owner of
the successful firm of Townsend & Greenspan garnered a PhD 30 years after
entering Columbia, and then moved on to a career in Central Banking.
Carret reports results for the index from 1892-1924, and concludes, "In
conjunction with other indicators, the blast furnace index forms the basis for
probable trends in stocks." While it is true that those who remember the
days
when pig iron was king fail to temper their calculations with the more
important factors of human capital, such as education, brand names, know-how
and customer loyalty, there is something that resonates through the ages about
the blast furnace index. In Carret's honor I have updated the index using
yearly data through 1995, a period equivalent to his lifespan as of this
writing. I used blast furnace capacity numbers up to 1975, and industry-wide
capacity data through 1994. The correlation between a yearly change in the
blast furnace index and stocks 12 months later is -0.20 (Figure F.1)
[Figure F1 is a scatter diagram with a negative sloping regression line
labeled Y=0.07 + (-0.11 * X) . The Y axis is labeled "Chg in DJIA
following
year", the X axis is labeled "Yr to Yr change in steel
capacity"]
As Carret says, "No trader can afford to disregard the suggestion." A
100% rise
year on year in the steel capacity index would forecasts a 4% decline in the
stock market the following year.
End of quote
Furthermore, by reference to amazon.com, it
is possible to ascertain who the
author of this Foreword to the paperback edition of Carret's book was. He is
personally known to many of us.
-- Alex Castaldo
Laurel Broadly Hints as to the Identity of the Writer of the Above-Referenced Foreword:
Could it be...Mr. V?
Trend following
Q. I am 25 years of age, and I must say that I am sorry to see you leave. I would very much like to be informed of any of your future ventures. Having worked for a hedge fund that had money with your brother; having read your book; having read a good majority of the Spec Duo's MSN articles, I have become pretty familiar with the Niederhoffer way of thinking. After having worked for a hedge fund that had money with trend-following funds such as Quadriga and Tuscon; after working with my current firm and its trading partners who are big proponents of trend-following...and are currently forming a fund with one of the original turtles, I have developed a good idea for the trend-following way of thinking.
I know this is not a simple way to answer the question that I am obviously posing here, but I have to ask. Why the huge freakin’ disagreement in opinions? Moreover, I would be very interested to hear your response to the turtle trader's retort to your past comments about the turtles...I am sure you have read their comments on turtletrading.com. This is probably not the sort of question you want to get into, but this is probably something that a good number of your readers would like to get a final thought on. I am just a young impressionable trader with an open mind looking for advice.
A. The results of the techniques you mention are selective, retrospective, and anti-statistical, and vitriol is guaranteed from those who must promote their wares. If the serial correlation is negative, then trend following won’t work, and any vagaries of those who make for this or that period are mere random flips. The market likes these random flips as it induces big money to go the wrong way, as so frequently happens and will happen vis-a-vis the shorts who made money especially on the negative side with the new millennium work. Add to this the implicit trillions to be lost by the market neutral delta hedgers.
There are markets like fixed income that have positive serial correlation. There the reversalists are fighting the bad fight. However, the cycles change, and just when everyone agrees that the trends are friendly in markets like foreign exchange, they're ready to change again. As for fixed income, the jury is out.
As for the small markets, the amount of money to be taken out by the strong and flexible is so great that there is no room for any fixed system to make money. I am convinced this is true in foreign exchange where the $50 billion or so that banks take out must be offset by all systems whichever way they go.
I am particularly displeased by all the hateful things that those who use these market systems say about me and my book, because it leads to an environment where unpleasant threats against me are often made, and damages one's reputation, which has so many real lacunae to overcome on its own. – Vic
Faith
Q. "Do you believe that ANYONE in the country can select winning stocks? Two experts on CNBC at the same time have exact opposing views: One says, 'Should be buying,' other says, 'Should be selling.' Then as far as particular stocks or funds, they not only disagree, but a winner for a while is the biggest loser the next period. When I retired four years ago, I took my broker's advice and put ALL my savings into four different mutual funds (for safe diversity). I will never regain even the amount I put in." (The reader is a former minister, a faithful breed that strangely seems to be quite attracted to our column, which includes rabbis, reverends, and many other doctors of divinity in the vicinity of its readerhood.) (6/22/3)
A. First of all, never give up faith. By the end of 2005, the Dow should be back above its old highs the same way the pre-crash 1987 highs were exceeded when only the strong longs and people of faith were left. As for whether anyone can make money in the market, if you take out the cane after huge declines at the end of the day, and buy, you should be able to retire to a stately mansion (but not in Nasdaq over the last three years).